Question

Niglow Corporation produces metal castings. In the past year it earned a 10% return on its net operating assets base of $10 million. Niglow needs $10 million to expand its operations, and has the option of obtaining none, some, or all of the proceeds from the bank. Currently the company is all equity financed. It expects to be able to maintain its return on net operating assets after the expansion. The bank has indicated that the amount it will charge on the loan will be dependent upon the resultant debt/equity ratio. Specifically, the rates will be 8%, 9%, 10%, and 12% for debt-to- equity ratios less than or equal to 0.25, 0.5, 1.0, and over 1.0, respectively. Niglow's tax rate is 40%.

a. Calculate Niglow's return on common equity if the expansion is financed:

i. using all equity
ii, 50% debt, 50% equity
iii. all debt.

b. What would Niglow's return on net operating assets need to be for the return on equityo be decreased by financing the expansion using all debt.

Answer 1

a. Calculate Niglow's return on common equity if the expansion is financed:

i. using all equity

since the company has no debts, equity = assets

return on equity = 10% = $20,000,000 x 10% = $2,000,000

ii, 50% debt, 50% equity

total debt $5 million, so after tax cost of debt = $5,000,000 x 9% x (1 - 40%) = $270,000

total return = $2,000,000 - $270,000 = $1,730,000

return on equity = $1,730,000 / $15,000,000 = 0.1153 = 11.53%

iii. all debt.

total debt $10 million, so after tax cost of debt = $10,000,000 x 10% x (1 - 40%) = $600,000

total return = $2,000,000 - $600,000 = $1,400,000

return on equity = $1,400,000 / $10,000,000 = 0.14= 14%

b. What would Niglow's return on net operating assets need to be for the return on equity to be decreased by financing the expansion using all debt.

total return = $999,999 or less

total return = operating return - $600,000

$999,999 + $600,000 = operating return

operating return = $1,599,999 or less